ACKNOWLEDGEMENTS

November 4, 2018 - 0 Comments

Recognition must be giving to Prof. Werner Antweiler, University of BritishColumbia, Vancouver BC, Canada for granting the permission to reproduce thegraph image of exchange rate fluctuation, on the basis of which I have mademy assignment. I would also like to thank my Lecturer and SubjectCoordinator Assoc. Prof. Ann Hodgkinson for her guidance and useful tipswhich have helped me in completion of this task.

ABSTRACTThis assignment defines the exchange rate and then introduces two differentways by which the price of a currency can be determined (fixed or floatingexchange rates). Finally discusses and analyses some of the most importantfactors which have caused changes in exchange rate of Australian Dollarsduring the last five years and give conclusion on the basis of analysis.

INTRODUCTIONAn exchange rate is the rate at which one currency can be exchanged foranother. In other words, it is the value of another country’s currencycompared to that of your own. If you are traveling to another country, youneed to “buy” the local currency. Just like the price of any asset, theexchange rate is the price at which you can buy that currency.

There are two ways the price of a currency can be determined againstanother. A fixed, or pegged, rate is a rate the government (central bank)sets and maintains the official exchange rate. A set price will bedetermined against a major world currency (usually the U.S. dollar, butalso other major currencies such as the euro or yen. In order to maintainthe local exchange rate, the central bank buys and sells its own currencyon the foreign exchange market in return for the currency to which it ispegged.

Unlike the fixed rate, a floating exchange rate is determined by theprivate market through supply and demand. Generally countries which havemature stable economy market adopts floating exchange rate. A floating rateis often termed “self-correcting,” as any differences in supply and demandwill automatically be corrected in the market. For example, if demand fora currency is low, its value will decrease, thus making imported goods moreexpensive and stimulating demand for local goods and services. This in turnwill generate more jobs, and hence self-correction would occur in themarket. A floating exchange rate is constantly changing. The Australiangovernment floated Australian dollar in December 1983.

FACTORS DETERMINING THE FLOATING EXCHANGE RATESRelative Price LevelsAlso known as the “Law of One Price,” which states that if two countriesproduce an identical good, the price of the good should be the samethroughout the world no matter which country produced it. The applicationof this law into real life is often referred to as Purchasing Power Parity(PPP). PPP theory states that exchange rates between any two currencieswill adjust to reflect changes in the price levels in both countries.

Therefore, when the prices of country X’s goods rise (holding prices offoreign goods constant), the demand for country X’s goods falls until itscurrency depreciates so that it can still sell abroad. Thus, over the longrun, a rise in a country’s price level (relative to foreign price levels)causes its currency to depreciate, and vice versa.

Tariffs and Quotas or Government PoliciesFirst we must define these two terms before examining their impact onexchange rates.

. Tariffs: Refers to the taxes levied by a country on the goods itimports.

. Quotas: Refers to the physical restrictions levied by one country onthe quantity of specific foreign goods that can be imported.

Imposing these taxes and restrictions (trade barriers) on foreign goodscreates an increase in demand for domestic products. The result of whichwill be an increase in the comparative value of that country’s currency.

That is because barriers rid foreign products of their competitive abilityin terms of price. Thus demand on domestic products flourishes. Accordinglybuyers will demand less of the foreign currencies and more of the localcurrency, causing the above mentioned price increase in the local currency.

Tariffs and quotas have a positive long run effect on a country’s currency.

Under the floating system Australian government through RBA (Reserve Bankof Australia) can interfere directly (by buying or selling foreignexchange), indirectly (by changing the level of interest rate) or byadaptation of macro-economic mix policies to increase or decrease the rateof economic growth in Australia in relation to rest of the world.

Consumer Preferences of Domestic Vs Foreign GoodsThis factor revolves around the mechanism of supply and demand. Basicallyif country X begins to demand more of the goods of country Y, i.e. increaseits imports from country Y, then the value of country Y’s currency willrise. It happens simply because when country X imports from country Y, ithas to purchase country Y’s currency to conclude the transaction.

Therefore, an increase in imports will result in an increase in demand forcountry Y’s currency, which in turn will result in an increase in price ofcountry Y’s currency. Therefore it can be concluded that increased demandfor a country’s exports causes its currency’s comparative value to increaseover the long run. Likewise, increased demand for imports causes thedomestic currency to depreciate.

ProductivityBy definition, productivity refers to the ability of the factors ofproduction to produce goods and services with a minimal consumption ofresources. Thus an increase in productivity refers to a more efficient useof resources, thus indicating a cheaper production process. If we applythis mechanism on a larger scale, such as that of countries, it would bepossible to identify the effect of productivity levels on exchange rates.

Increasing productivity leads to a decrease in production costs and thusprices. This comparative advantage will result in both a local and foreignincrease in demand for the goods of, let’s say, country X for example. Thiswill lead to an increase in demand for country X’s currency causing itsvalue to rise in comparison to other currencies.

Interest Rates on Exchange RatesNow a days there is a high level of capital mobility that is, foreignerscan easily purchase local assets, such as Australian dollar deposits, andlocals can easily purchase foreign assets such as U.S. Dollar or FrenchFranc deposits etc. Since foreign and local bank deposits have similar riskand liquidity, and there are few obstacles in front of capital mobility, itis reasonable to assume that both local and foreign deposits are equalsubstitutes, and thus should be equally desirable. When this situationoccurs, if the expected return on Australian dollar (i.e. interest rates)is above that on foreign deposits, both foreigners and Australians willwant to hold only Australian dollar deposits and will be unwilling to holdforeign deposits. Thus interest rates are the value of a currency, and thecurrency with the highest expected return value i.e. interest rate, willexperience an increase in its relative value, or exchange rate, incomparison to other currencies, once again the opposite is also true.

But interest rates exhibit only a short-term effect on exchange rates i.e.

on a daily basis or even shorter, that is due to the multitude andfrequency of the daily transactions carried out in the capital market. Forexample, foreign exchange transactions in the US each year are well over 25times the amount of US exports and imports all together.

ANALYSISNow that important factors affecting exchange rates have been discussed,fluctuation in Australian Dollar in last five years can be reviewed withthe help of a chart (see appendix).

By late 1998 the world economy became very uncertain but 1999 was period ofrelative calm. For Australia it was a good year although Australian economywas caught up in some of the early instability in world financial market.

The Australian performance over the two years since the Asian crises began,has attracted international attention and improved its understanding ininternational market. Domestically, year 2000 was a successful year for theAustralian economy with strong growth rate and falling unemploymentalthough inflation was higher then it had been for several years. Apartfrom overseeing the smooth transition in to new century (due to Y2Kproblem), the period was quite uneventful. The Australian economy enteredthe new century while growing strongly, as it had done for most of the1990’s. It showed similarity to rest of the world with one difference thatwas the transition effect of introduction of GST which caused anexceptionally sharp temporary contraction in house building in the secondhalf of 2000. This in turn resulted in the small fall in GDP in the sameperiod before moderate growth resumed in first half of 2001. The majordevelopment in 2000/01 was the designation of the three credit card schemesoperation in Australia so that the payment system board could determine theregulation applied by the schemes. The world economy experienced verysluggish growth in 2001/02 with the two biggest economies, the UnitedStates and Japan. The event of September 11th added additional element ofuncertainty and it seemed that condition might worsen in 2002. In theevent, slow and uncertain recovery occurred despite further economic shocksin the form of sovereign debt crises and the revelation of seriousdeficiencies in corporate governance in the United States.

RBA eased monetary policy three times in the second half of 2001 that wasonce before September 11th and one after it. On all three occasions, theeasing was motivated by a desire to preempt the effects on Australia of aprobable downturn for the world economy was unlikely, monetary policy wastightened again in the first half of 2002.

In the first half of 2003, the world economy received further disruptionfrom the short lived Iraq war and fear that the outbreak of Sever AcuteRespiratory Syndrome would turn in to a major epidemic. Australian economyperformed well throughout the year but there was a clear difference in tonebetween the beginning and end of year. By the end of the year with furtherfall in world interest rates and talk of further deflation abroad, both ofwhich were leading to a rising Australian dollar. There were no changes inofficial interest rates in 2002/03 in Australia.

CONCLUSIONAfter a thorough analysis of exchange rates fluctuation of AustralianDollar in past five years, it can be concluded that there are severalfactors which have caused these change. But the most important factor isgovernment policies which are implemented by government through RBA inorder to support the economy and keep the right balance in inflows andoutflows in both domestic and international markets.